No Cheer this Year: What to Do in a Bear Market

December is normally a good month for stocks. Since 1950, the S&P 500 index of large U.S. stocks has increased 75% of the time. This year is different, and the stock market is not bringing any holiday cheer.

By the Wednesday (12/20) close, the S&P 500 was down 9.1% for December, in line for one of its worst months ever. The S&P is 14.0% off its high reached on September 20 and shows a loss of 4.5% for the year. The broader MSCI All World Stock Index is down 17.4% from its January high and is off 8.6% for the year.

While neither index is technically in bear market territory, generally considered a 20% or greater decline from most recent highs, the rapid fall in stocks after an unusually long positive run is unnerving. Many investors are concerned that a confluence of scary events will drive stocks even lower.

What’s Going On?

Normally, diversification helps smooth out the ups and downs. If stocks are not doing well, bonds usually smooth out the action. If inflation concerns are hurting bonds, commodities or real estate tend to do well. But, this year, nothing is working.

The stock market is worried about higher interest rates, a growing trade war with China, and a slowing global economy that could spill over to the U.S. The bond market is driven by expectations for higher interest rates, which would mean lower bond prices.  Falling oil prices hurt commodities, and real estate is just tired.

The U.S. economy, while still performing very well now, is still subject to business cycles as companies and consumers overreach during good times and have to pull back. It’s all part of a normal sequence of events throughout history. While technology has drastically impacted our standard of living and our very existence, human nature hasn’t really changed much over the last 100 years.

What’s next? Will stocks enter a prolonged bear market or is the current downturn temporary? 2015 was set up similarly for investors. The Fed was just starting to talk about higher interest rates against the backdrop of a soft global economy. Stocks, bonds and commodities were all declining. The market turmoil convinced the Fed to back off on raising rates, and investors reacted by pushing the S&P 500 to a 9.5% gain the following year.

It could happen again, but we would not recommend counting on it. Most likely, the Fed will stay the course for now.

Fundamentally, we believe that successful investing is not about calling tops and picking bottoms. As difficult as it is, investors should try to resist the temptation to measure their long-term success by looking back at the peak value in their brokerage statements.

Stocks will, in fact, suffer a bear market decline somewhere along the way. Some will panic and sell at the most inopportune time. Others, grounded in a solid long-term plan, will stay the course and come out the other side of the downturn to reap the returns.

Successful investing is also about protecting your portfolio from costly behavioral mistakes. We wish we could tell you when to sell everything and go to cash. Unfortunately, we can’t, and no one else can either. We can help you build a reliable plan so you can sleep well at night and not be tempted to sell at the wrong time.

What to Do in a Bear Market

Here is what we believe you should, and should not do, in a bear market:

Do: Base your allocation to stocks and other risky assets on careful planning. Bonds and cash should total enough to provide three years of living expenses. Extend that to five years if you are not still working.

Do: Rebalance your portfolio, at least annually if not more often, back to your strategic targets for stocks, bonds, and cash reserves.

Don’t: Chase returns. Chasing returns is a recipe for disaster in any market, but especially during a bear market. The best shelter during a downturn is found in higher quality stocks. We look for companies showing consistent earnings growth, low levels of debt to total capital, and historically strong returns on equity. Bonds should be investment-grade or higher.

Do: Manage taxes through judicious use of tax loss harvesting.

Don’t: Try to time the market. It won’t work, and the opportunity costs are too high.

Even though a correction in stock prices has been expected for some time, it's always scary when the actual event arrives.  Still, we don’t see the bottom falling out of the economy or the stock market. The reality is that this type of movement is always part of the equation for stock investors. Ultimately, we believe this will be a normal correction that will run its course.

For investors with strategically diversified portfolios, it should have no major impact on life plans.

Regardless, we will monitor developments closely and let you know if new information is available. We will also provide more in-depth analysis in our upcoming year-end letter. In the meantime, please don't hesitate to contact us with any specific questions or concerns.